Alternative-strategy funds thrive despite spotty record

Advisers are pouring money into mutual funds that employ alternative strategies, a sign that they are still looking to reduce risk in their clients’ portfolios despite a market rebound.

Meanwhile, many of the funds sporting alternative strategies are underperforming the market, though that hasn’t stopped their growth.

Flows into alternative funds, which are mainly sold by advisers, reached $14.7 billion in 2010, up from $10.8 billion in 2009 and $3.4 billion in 2008, according to Morningstar Inc. Based on figures through June 30, flows this year are on track to match 2010 figures.

Total assets in open-end funds that use alternative strategies — not including precious-metals or real estate funds — stood at $87.9 billion as of the end of May, according to Lipper Inc.

Alternative mutual funds are “really growing at rapid clip,” said Nadia Papagiannis, an alternative-investments strategist at Morningstar.

That’s despite a sharp stock market rally since early 2009 that should be producing head winds for alternatives, which are designed to reduce risk rather than generate juicy returns.

Advisers, however, still want “to mitigate risk in client portfolios,” said Jeff Tjornehoj, head of Lipper research for the Americas.

The trend will continue, said Robert Mileff, director of alternative investments for Fortigent LLC, which provides outsourced money management services for advisers.

“Demand [for alternatives] is just exceptional right now,” Mr. Mileff said. “We see where advisers are putting assets, and it’s in mutual funds because of the liquidity and transparency.”

Despite the increased demand, results have been lackluster in most categories of alternative funds — excluding the real estate and precious-metals sectors.

Compared with the average S&P 500 index fund, which returned 3.1% on an annualized basis for the three-year period ended June 30, market-neutral equity funds eked out a 0.4% total return, while the more tactical long/short fund category lost 0.23%, and 130/30 funds gained 0.45% on average, according to Lipper.

The three-year comparison period includes the bulk of the 2008-09 sell-off and the subsequent bounce-back. Managed-futures funds, meanwhile, also struggled, losing an annualized 2.68%, according to Morningstar.

Bearish funds did even worse. Over the three-year period ended June 30, Morningstar’s bear market category lost 23.49% on average. Over the five-year period, which encompasses all of the downturn, bearish funds lost 16.64% on an annualized basis, compared with a gain of 2.94% for the S&P 500.

“There’s a lot of bad product out there,” Ms. Papagiannis said about alternatives in general.

“You have to really search” for good managers, Mr. Mileff said. “That’s why we’re slow [to recommend new products], and we get criticized for it.”

“What’s embarrassing is that so many [funds] show negative numbers from 2008, although they fared better than the broader stock market during that period, Mr. Tjornehoj said.

“Some that should have shown a bigger pop in 2009 were the 130/30 funds,” he said. “They got hit more on the downside than they should have, but couldn’t show up in 2009” for the rally.

Some of those funds may have mistimed the market or suffered from outflows, Mr. Tjornehoj said.

Many long/short equity funds and market-neutral products have been disappointing, Ms. Papagiannis said, because they must rely on the rare manager who is skilled at producing alpha. The funds cannot count on market direction to produce returns.

LOST IN TRANSLATION

Even good hedge fund managers don’t always do well in a mutual fund structure, observers said.

For example, highly leveraged strategies such as arbitrage are difficult to run within the constraints of a public fund, Mr. Mileff said.

“Most of these things, unfortunately — because they’re fairly new — don’t have extremely long track records,” said Robert Kresek, managing partner at Founders Financial Network LLC, which manages about $560 million.

“A lot are [run] by institutional fund [managers] that have come out with mutual funds,” Mr. Kresek said.

“They claim they will do as well” as their hedge funds, he added.

Mr. Kresek is still window shopping for pure alternative funds. He is considering adding several products from AQR Funds.

Analysts said there are some good ones to consider.

Ms. Papagiannis likes the AQR Diversified Arbitrage Fund Ticker:(ADANX), which uses a number of arbitrage strategies and “has some potential for capital appreciation.”

She also favors the JPMorgan Research Market Neutral Institutional Fund Ticker:(JPMNX), based on the strength of the firm’s research; the Wasatch Long/Short Fund Ticker:(FMLSX), which uses a number of hedging strategies; and the Merk Hard Currency Fund Ticker:(MERKX), for a diversified basket of currencies.

Mr. Mileff likes the Turner Spectrum Fund Ticker:(TSPEX) and Turner Titan Fund Ticker:(TTLEX), long/short products built around sector-specific fundamental research, and the Driehaus Select Credit Fund (DRSLX), a flexible corporate-bond fund that uses arbitrage strategies.

In addition, both Ms. Papagiannis and Mr. Mileff like the TFS Market Neutral Fund Ticker:(TFSMX).

Email Dan Jamieson at [email protected]

Related Topics: Alternative Investments Conference